How Stocks Grow

I’m just thinking this through like a child or an alien. These are meant as broad strokes, just to rethink this, and remind myself, as I periodically do. As usual, this is stream of consciousness, from what I happen to know or believe now, without doing any new research as I write.

Of course stocks need money to grow. The sum total of money flowing in to stocks has to be more than the money flowing out, for stocks to go up. This money must come from somewhere.

How debt grows stocks

Money is minted when debt is issued. Modern money is debt. When a person or business or government borrows money, a bank generates money, by the power vested in it by its government, it creates money to lend to the borrower. This is simplified, but essentially true.

(They are supposed to have 10% of what they lend, although they could have got that 10% as a deposit from someone who took it as a loan from another bank, or someone paid with a loan…the bank’s 10% is not necessarily something tangible, like gold.)

The borrower then buys a house, or a car, or burrito, somehow injects the money in to the economy. And that currency transaction gets added to the GDP. Then the next guy in line can spend it or put it in the bank and spend it later. If they spend it again, that transaction also gets added in to the GDP.

The bank who issues the debt writes that in their books as an asset. To the bank, a loan is like dark matter, or mirror money. If they loan $1 million, they have $900k in new assets, which is paying them at 5% interest, or whatever. They just made $900k on a $1m loan. They can then re-loan the money they have just loaned, or pay business expenses, or reinvest it.

I don’t know banks rules on reinvesting their profits from loaning money. But even if they didn’t have that rule, let’s just say they pay their employees, and board members. There are many notoriously highly paid people in banking.

The money that is loaned to people or small businesses is largely injected in to the economy, creating real transactions for production of actual physical stuff, and services. All of this activity is the GDP that drives businesses, which grows the profit of companies, and the value of stocks.

But who buys these stocks? Anyone who has enough money to save. It’s also notorious that the majority of people don’t have enough spare money to save. Something like 50% of people have no savings, and so no stocks.

The more money people make on top of what they spend to live, the more they can afford to spend on stocks. So, for instance, a banker with a $100 million salary can buy a lot of stocks. As much as a 1000 or 10,000 middle class working people.

I don’t know the actual proportions, but in general, clearly, when money is generated, and grows the economy, it disproportionately flows through high net worth individuals, in to stocks, and other investments, and this is becoming increasingly exaggerated over time, because it’s an aggregative process.

And also, businesses can borrow money, and then reinvest that money in stocks. And with negative interest rates in Europe, some companies are paid to borrow money. This seems to be an act of desperation by the banks, to keep GDP’s head above water, above zero, out of recession…but it also is a windfall to the businesses borrowing. Banks can also be paid to borrow money, then re-loan the money at interest, if they can find qualified borrowers.

Using 2009 through 2014 for instance, to follow the flow of currency, a chart of the broad stock market, the SP 500, clearly shows an explosive influx of buying, exactly correlated with the “quantitative easing,” the government authorized creation of about $4 trillion in new debt, by borrowing it in to existence.

This money was created ostensibly to “prime the pump,” stimulate the economy, in order to get currency flowing through peoples’ hands. But clearly it also had the effect of replacing all the debt based money that was disappearing from existence as people defaulted on mortgages.

When the money was borrowed in to existence, some of it was spent through the government, in order to inject it in to the economy, and push it through peoples’ hands. But ideally, banks, who now had this money on their books, could find qualified private borrowers, business and people, who could borrow it again, growing the economy, and the banks’ books.

In either case, the banks continued to make money, and pay big salaries, and bonuses. So their principles and executives could go on stock buying sprees. It’s well known that the economic “recovery” from 2009 was very weak, in contrast to the explosion in stocks and bonds and even gold, and also in contrast to other recession recoveries.

Weak means, for the majority of people, 95% ish, standards of living remained stagnant as they had for a decade already, even as the GDP grew. The extra spending that drove the recovery came from a smaller and smaller percentage of the population.

This begs the question, how far this can go. How far can 5% of the population drive a growing economy? Can 5% of the population do enough over consumption to drive enough goods and services to generate a living wage or welfare for the rest? Can 3%? Or 2%?

The Trump rally

And more immediately, what about the Trump rally? If QE drove the run from 2009-2014, by printing money, which was injected in to stocks as reasoned above, is there new money being created since the Trump election? Where is the money coming from, that’s ballooning stocks?

The government has not started increasing the deficit (creation of new money through public borrowing), so it would have to come through private borrowing.

Rates are low, and maybe business enthusiastic about his policies are on fresh borrowing sprees? Or maybe it’s still Chinese money. China is still on a notorious debt creation bender. Anyway, the point is, for stocks to go up, the money has to come from somewhere.

Bonds

Often stocks and bonds are thought to be inversely correlated. So that money could flow out of the much bigger bond market, in to stocks, driving bonds down and stocks up.

And in fact, bonds did crash on Trump’s election, right in sync with the stock boom.

The two downward pressures in bonds are 1. If people sell them to buy something else, like stocks or gold, or 2. If the fed raises rates, so that new bonds pay more interest, therefore old bonds are worth less. With Trump, we have both pressures, so far.

What’s next?

The EU is planning to stop it’s QE printer in early 2018. The US Fed is on a rate increase trajectory, which is supposed to slow borrowing, but in this case is probably mainly intended to build a buffer of interest in order to cut it again, probably sooner than later. China seems to be near limits of debt to GDP ratio, which could be calamitous. So it’s not hard to imagine central banks might be coming up a limit to growth through lending, for a while.

However, since the bond market is 3x bigger than the stock market, more money could come out of bonds, and drive stocks higher. The US fed slowly raising rates also supports this flow, although bonds have already come down almost 20%, since Brexit….almost exactly the same amount the SP 500 went up since then!

However, since the bond market is bigger than the stock market, it would have only taken some of the money coming out of bonds to drive stocks this far. Some of the bond money must be going somewhere else. Possibly in to business.

In retrospect, the mind of the market is almost childishly simple. The view of Trump was that he was good for business and the economy, so stocks should go up, and the fed should be able to keep raising interest rates, so bonds should go down.

All the complicated thinking about how or if this will work out was irrelevant to making money. If you’d sold bonds and bought stocks it would have been the right choice, for Trump’s first 6 months.